The bond market reacted to last Friday’s better than expected employment report as it typically does to any stronger than expected economic report. Treasury bond prices declined and yields increased and corporate bonds, lower rated issues in particular, outperformed on the day. However, the reaction from Treasuries was relatively muted considering the upside surprise in the employment report and prior reactions in the Treasury market.
On June 5, the release of the May employment report also surpassed expectations with payrolls declining 345,000 versus a consensus forecast of a 520,000 decline and caused a strong sell-off in the Treasury market. On the day of, the 2-year Treasury note spiked by 0.34%, while the 10-year note jumped by 0.12%. Similarly, on August 7, the July employment report showed a decline of 247,000 jobs versus the consensus forecast of a 325,000 decline and Treasury yields also jumped higher [See table] on the day. Last Friday, yield increases of 0.09% and 0.08% for the 2- and 10-year Treasuries was the most muted for an above consensus employment report.
At first glance, last week’s market response does not seem terribly different but after considering the broader market environment it stands out. First, since the May and July employment reports, the economic data overall, not just employment, has reflected additional improvement. Second, on an absolute basis, the November employment report was the best of the recovery thus far and shows the economy on the precipice of adding jobs. Lastly, Treasury yields entered the employment at much lower yield levels than prior to the May and July employment reports. Taken together the Treasury market sell-off should, if anything, have been much more violent this time.
Treasury Market Resiliency
The approach of year-end has been the primary driver in Treasury market resilience to a better than expected jobs report. As year-end approaches corporations and financial institutions prepare to tidy up balance sheets in preparation for year-end reporting and buy high quality short-term investments such as T-bills. The move to high quality short-term investments is also done as part of risk management. With staffing typically light over the holidays, both at institutions and at major bond trading firms, there is little desire to enter the last two weeks of the year heavy on risk bearing positions. If a negative event occurs it is more difficult to exit such positions.
Year end funding demand is evident in negative t-bill yields. All T-bills maturing in January closed last week with yields just in negative territory at negative 0.05%. In essence, the bond market is making investors pay a premium for yearend protection. For some investors, the negative 0.05% yield is considered insurance for guaranteeing the safety of their principal.
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The Federal Reserve (the Fed) has also been a factor as bond investors have credence in their “extended period” messaging. Despite economic data showing improvement, bond investors have put more faith into benign Fed comments and their commitment to keep rates low. The upcoming FOMC meeting on December 15 – 16 will likely be the last opportunity for the Fed to alter their message to the markets in 2009. We do not believe they will do so however and will likely maintain the “extended period” language in the FOMC statement. It is unlikely Fed Chairman Ben Bernanke and company would risk upsetting market participants with year-end liquidity needs just around the corner.
Although Treasury yields did increase following the better than expected employment report, the increase was relatively muted. Considering previous market reaction, the extent of additional economic improvement, and lower overall level of Treasury yields, we would have expected a stronger sell off in Treasuries. The approach of year end was the primary factor in keeping the Treasury move subdued and investors’ confidence in the Fed’s message to keep rates low also played a role.
Over time the Treasury market will not be as ambivalent to further positive strides in economic data. The Fed will also have to acknowledge improvement and may signal as much at the January 27 or March 16, 2010 FOMC meetings. We are biased towards a later shift, either at the March FOMC meeting or after. Once that occurs Treasury yields would likely be pressured steadily higher. Until then, we believe Treasury yields will remain relatively range bound. Year end funding needs will likely continue to play a dampening role on any upward move in Treasury yields over coming weeks.
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